buffOne of the most highly anticipated events in the annual business cycle is the March release of Warren Buffett’s letter to the shareholders of Berkshire Hathaway. Many investors and observers look forward to the letter for the business and investment insights that Berkshire’s Chairman provides, as well as for his plain-spoken style and homespun humor. This past Saturday morning, Berkshire released this year’s shareholder letter along with the company’s 2013 annual report. Though there is much in this year’s letter that will be familiar to long time Buffett fans, the letter contains a number of interesting new observations as well – about Berkshire, about the U.S. economy, and about investing. (Full disclosure: I own BRK B shares, although not as many as I wish I did.)


Much of the attention on Buffett’s letter and the Berkshire annual report will be on the company’s financial performance during 2013 – and rightfully so, as the company’s diverse operations performed well. As Buffett himself says in his shareholder letter, “just about everything turned out well for us last year – in certain cases very well.” Full-year profit rose 31 percent to $19.48 billion, or $11,850 per Class A share, while operating profit rose 20 percent to $15.14 billion, or $9,211 per share.


Notwithstanding these results, it would be a mistake just to focus on the company’s relative performance during a single 12-month reporting period. Obviously, it is inherent in the nature of annual reports that the company in question will be considered in an annual snapshot perspective. But if Berkshire is only considered on this annual reporting period basis, a much more meaningful message might be overlooked. Simply put, Berkshire Hathaway is an astonishing company, and it is becoming even more so all the time.


Let’s start with the company’s balance sheet. The company reported year end assets of $484.4 billion (representing an increase of about 12% from the end of 2012.). It is not just that the company now has assets of nearly a half a trillion dollars; the company’s assets have grown by an astounding 63% in the five year period ending in 2013. With the acquisition of a 50% interest in Heinz, the company now owns 8 ½ companies that if they were stand alone businesses would be in the Fortune 500.


The company ended the year with cash and cash equivalents of $42.6 billion, which at first glimpse might seem to be unchanged from $42.3 billion with which the company ended 2012. The thing is, the company ended 2013 with $42.6 billion in cash, even after spending almost $18 billion acquiring NV Energy and a 50% interest in Heinz; after spending $3 billion on what Buffett called “bolt-on” additions to existing businesses; after significantly increasing the company’s stock holdings in what Buffett called the company’s “big four” investments (Wells Fargo), American Express, IBM and Coca-Cola). After these and many other investments and expenditures, that the company ended the year with what might appear to be an unchanged cash position is remarkable.


The company’s  BNSF railroad operation (which is by far Berkshire’s largest acquisition ever) carries about 15% of all U.S. inter-city freight (whether transported by rail, truck, water air or pipeline) and is according to Buffett “the most important artery in our economy’s circulatory system.” The company now has 330,745 employees. On the one hand, that is not nearly as many employees as Wal-Mart has, on the other hand, Berkshire does now own 1.8% of Wal-Mart.


Buffett is himself famously self-effacing, but he feigns no modesty when he talks about his company. He refers to what he calls the company’s “supreme financial strength” – which, he adds, “we will always maintain.” He illustrates the importance of the company’s financial strength by examining what would happen if the insurance industry were to experience a $250 billion catastrophe loss, a loss that would be “triple anything it has ever experienced.” Were that to happen, Berkshire “as a whole would likely record a significant profit for the year because of its many streams of earnings,” while “all the other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.” 


Berkshire’s promises, Buffett states, “have no equal,” a fact that has been “affirmed in recent years by the actions of some of the world’s largest and most sophisticated insurers,” who have sought to “cede” liabilities, particularly those involving asbestos claims. When insurers seek to shed themselves of long-lived liabilities, “almost without exception, the largest insurers seeking aid come to Berkshire.” To illustrate this point Buffett details the largest transaction of this type, the company’s 2007 transaction with Lloyd’s.


Another thing that is clear about Berkshire from this year’s report is how substantially its operations have changed and expanded. For many years, Berkshire was a sophisticated investment company operating in the guise of an insurance holding company. Berkshire’s insurance operations are massive. But the company is now much more diversified. It is now a manufacturing, utilities and industrial holding company as much as it is an insurance company. Indeed, just the company’s railroad, utilities and energy business produced almost as much revenue in 2013 ($32.7 billion) as the insurance operations ($36.6 billion in annual earned premium). BNSF alone produced more in net earnings ($3.79 billion) as the entire insurance operations produced in terms of underwriting gains, even though the insurance operations produced a remarkable $3.09 billion in underwriting profit – the eleventh consecutive year the insurance operations have produced an underwriting profit. (The insurance operations does also produce “float” which creates an opportunity to produce investment gains on top of underwriting profit, which has to potential – particularly for Buffett – to produce even greater overall profits over time.)


Among the more interesting features of this year’s letter is Buffett’s lavish praise of the U.S. economy. Buffett is clear that Berkshire’s prosperity derives from its opportunity to invest in the economy of the United States. After recalling that at the time of Berkshire’s acquisition of BNSF in 2009 – in the midst of “the gloom of the Great Recession” – he called the transaction an “all-in wager on the economic future of the United States,” Buffett said that he and the Berkshire co-Chair Charlie Munger “have always considered a ‘bet’ on ever-rising U.S. prosperity to be very close to a sure thing.” Buffett asks rhetorically, “who has ever benefitted during the past 237 years by betting against America?” Buffett says that “the dynamism embedded in our market economy will continue to work its magic.” Even more encouragingly, he adds, “America’s best days are ahead.”


Indeed, in a short discourse about investing (which was previously published as an excerpt on the Fortune magazine website), Buffett recommends that unsophisticated investors make regular investments over time in a low-cost S&P 500 index fund, in order to own a cross-section of  businesses. Even though some businesses might disappoint, as a group they are certain to do well, particularly over the long haul.  As Buffett asks, with respect to the possibility that financial turmoil might cause some investors to sell valuable assets as some investor did during the recent financial crisis, “Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?”


Buffett does, however, sound one cautionary note about the U.S. financial environment. Local and state governments face daunting financial challenges, largely because the various entities made pension promises they cannot afford. Buffett includes within Berkshire’s annual report a letter he wrote to the Washington Post’s Katherine Graham in 1975 about the pitfalls of pension promises. (“Rule number one regarding pension costs has to be to know what you are getting into before signing up.”) As Buffett puts it in the shareholder letter, “During the next decade, you will read a lot of news – bad news – about public pension plans.” He stresses “the necessity for prompt remedial action where problems exist.”



Berkshire naysayers may seize upon Berkshire’s “underperformance” according to Buffett’s own measure comparing the change in the company’s per share book value relative to the change in the value of the S&P 500. The S&P 500 has beaten Berkshire four out of the last five years according to this measure, and in 2013, because of the S&P 500’s strong performance, the stock index (which increased 32.4%) outperformed the Berkshire per share value change by a difference of 14.2 percentage points.


Buffett points out that “both Berkshire’s book value and intrinsic value will outperform the S&P in years when the market is down or moderately up,” adding that “we expect to fall short, though, in years when the market is strong – as we did in 2013.” Buffett adds that “we have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%.” (Indeed, in the four of the last five years when the S&P 500 outperformed, the index’s gain exceeded 15%).


Anyone who thinks Berkshire shareholders are getting shortchanged will want to examine what happened in the years where the S&P 500 underperformed Berkshire. In those years, Berkshire’s results far outperformed the S&P 500. In the financial crisis year of 2008 for example, both the S&P 500 and the per share value of Berkshire declined, but while Berkshire declined by 9.6 percent, the S&P 500 declined by 37%, meaning that Berkshire outperformed by a difference of 27.4 percentage points. In 2002, when the S&P 500 declined 22.1%, Berkshire’s per share value increased 10 percent, a difference of 32.1 percentage points.


The fact is, Berkshire will have a hard time matching in the future its compounded annual gain of 19.9% for the period 1965-2013. Indeed, during the period 1999-2013, the company exceeded the 19.9% compounded annual gain only twice (2003 and 2009) – and in both of those years, the company’s change in per share value underperformed the S&P. The company has reached a size where it will be very difficult to achieve significant annual increases in per share value or even for the change in per share value to outperform the S&P 500 — except in years where the S&P 500 declines in value. Just the same, because Berkshire’s per share value is unlikely to decline as much as the S&P 500 in down years, the company will still outperform over the long run – just not as dramatically as it did in the years between 1965 and 1999.



There are many other interesting details in Buffett’s letter. For example, the list of Berkshire’s fifteen common stock investments with the largest market value has changed slightly from 2012. Two companies have dropped off the list and two have been added. The two that dropped off the list are POSCO (market value at the end of 2012 of $1.2 billion) and ConocoPhillips ($1.399 billion). The companies that joined the list are ExxonMobil (market value at the end of 2013 of $4.1 billion) and Goldman Sachs ($2.3 billion). It is interesting to note in light of Berkshire’s ownership of General Re that among Berkshire’s top fifteen common stock investments is an 11.2 percent ownership share of Gen Re’s big European rival, Munich Re (market value $4.4 billion). It is also interesting that of the top fifteen common stock investments, only one carries a market valued below cost – Tesco, with a cost of $1.699 billion and a market value of $1.666 billion. Overall, Berkshire’s fifteen investment holdings have an aggregate cost of $56.5 billion and an aggregate market value of $117.5 billion.


Buffett also has some interesting comments in his letter about Gen Re, which still remains Berkshire’s second largest acquisition. He is full of praise for the reinsurance unit’s recent performance. However, he adds that “It can be remembered that soon after we purchased General Re, the company was beset by problems that caused commentators – and me as well, briefly – to believe I had made a huge mistake. That day is long gone. General Re is now a gem.” While flattering of the company now, this statement also conveys Buffett’s lingering ill feelings about the unit’s former management, who had to contend with the fallout from 9/11 and who then resigned amidst a variety of legal proceedings and investigations. I am sure my former colleagues at Gen Re are glad to receive Buffett’s current praise, but I suspect that his implicit rebuke of former management gives many of them a chill. Those of us who can remember will recall that there was a time when Buffett lavished praise on the now former-management as well.


As fascinating as both the shareholder letter is in many ways, it does have a certain repetitive quality. Once again, Buffett blasts the rest of the insurance marketplace for its lack of discipline, even repeating for the third year in a row his criticism of GEICO-competitor State Farm, which incurred an underwriting loss in nine out of the last twelve years through 2012 (the last year for which State Farm’s results are available). Like a talkative dinner guest, Buffett trots out the well-worn story about Rose Blumkin and the Nebraska Furniture Mart, and how as an immigrant she built up a very successful business. Not only that, but parts of his letter are nothing more than advertisements for Berkshire businesses. He not only announces the opening of a new Nebraska Furniture Mart store in Texas and broadcasts the formation of the new Berkshire Hathaway Specialty Insurance unit, but he even includes the phone number to obtain a GEICO insurance quote.


But while Buffett is sometimes repetitive and though his tone can sometimes edge toward hucksterism, he exhibits other traits that no other CEO displays. Buffett is brutally honest and self-critical about his 2007 decision to invest in Energy Future Holdings (a decision he admits he made without consulting his sidekick, Charlie Munger), which resulted in a $873 million before-tax loss. In the context of a company with revenues of over $180 billion and profits of $19.4 billion, there is no reason for Buffett to call attention to this one investment loss, even at $873 million. Many CEOs made dreadful mistakes in the run up to the financial crisis. How many other CEO’s would call themselves out on a misstep like this, where there was no need to do so?


Buffett’s track record is unparalleled and he has earned the high regard that he enjoys. But the question everyone will ask is – how much longer can he keep it up? Buffett does take pains in his shareholder letter to lavish praise on his two investment protégés, Todd Combs and Ted Wechsler, both of whom we are told not only outperformed Buffett in 2013, but outperformed the S&P as well. They each now run portfolios exceeding $7 billion. But are they ready to manage Berkshire’s entire investment portfolio and future investment strategy?  And even if they can manage the investments, who will run the company? The shareholder letter is full of the names of various Berkshire unit Presidents, many of whom may are highly successful. Just the same, the question of management succession at the top will only grow louder and more insistent. My household happens to include someone exactly Buffett’s age, and all I can say is that I sure hope Berkshire’s board is keeping a very, very close eye on Buffett.


For now, Buffett and his company remain virtually synonymous. But the day is coming when Berkshire shareholders will have to confront the reality of Berkshire without Buffett. When that day comes it will mean many changes — not the least for many of us, it will mean the end of the invaluable annual letter to shareholders. For now, then, let us celebrate the letters while Buffett is still producing them.  Buffett closes this year’s letter noting that next year’s letter will be the fiftieth and that he intends to use the letter to review the company’s prior 50 years and “to speculate a bit about the next 50.” That sure sounds like a perfect opportunity for a valedictory production to me.